You can almost ignore inflation when it runs at 2%.
Sure, it’s insidious. It will sneak up on you and, over time, that 2% will compound and erode your purchasing power.
But 2% inflation is what the Federal Reserve wants. It’s most consistent with the Fed’s other goals of maximum employment and stable prices.
You can’t ignore inflation running at 7% year over year like it did in December. That’s enough to double prices in just 10 years!
In my opinion, I don’t expect prices to continue running hot like this. In fact, as I said at the end of last year, I expect inflation to taper off by the second half of 2022. We could even see prices fall.
But all the same, the great inflation spike of 2021-22 should drive home several important points.
Ignore these at your peril.
Margin of Safety
The first is the all-important margin of safety. The always quotable Warren Buffett has joked that he likes investments that wear a belt and suspenders. He doesn’t want any of his investments caught with their pants down.
Let’s apply similar logic to our retirement portfolios.
If you can pay your bills in retirement with a 4% return, you can’t arrange for your portfolio to generate a 4% return.
That’s cutting it too close.
You need to target a 6% return or even higher. That way, should you fall short for any reason, you have some leeway.
Your other alternative is to ensure that your expenses are flexible and can be scaled down. In a perfect world, aim for higher returns and flexible expenses.
The end goal is to create a large enough margin of safety that you are always outrunning inflation.
Growth Over Yield
In my view, a stock with high yields is at risk of cutting its dividend. Or, at the very least, it’s a lumbering, slow-growth fossil of a company.
In my opinion, anything paying out a double-digit dividend should be scrutinized.A dividend that seems high today won’t be high tomorrow if it doesn’t grow.
In order to keep pace with inflation — even the milder 2% to 3% variety I expect — you need dividend growth. And dividend growth is only possible with earnings and cash flow growth.
Again, if you want to make sure you don’t lose purchasing power over time, I believe your dividend stock portfolio should also be heavy on growth.
Finally, remember that your nominal return isn’t what you take home. The taxman will always take his bite.
So, you need to factor the tax rate into returns estimates.
If you know for a fact that a stock pays qualified dividends, then you can safely budget a 20% tax rate. (Qualified dividends have a tax rate of 0%, 15% or 20% depending on your filing status and taxable income.) Your 5% gross return becomes a 4% net after tax if the tax rate on that dividend is 20%.
But keep in mind tax rates change.
This brings us back to my first point: that all-important margin of safety in my opinion. Always make sure you’re earning more than you need so that any unexpected hiccup — such as a change in tax rates — doesn’t throw a major wrench in your retirement plans.
This post first appeared on January 20 on the Money & Markets blog.
Photo Credit: Nicolas Raymond via Flickr Creative Commons
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